Fundmastery Blog

Kurt Brouwer December 10th, 2007

The words banking and crisis are being linked now and, to an extent, it is a crisis that reprises one that happened 20 years ago or so. Right now, we have the subprime lending mess. Twenty years ago we had the savings & loan crisis as this article points out. By the way, in the article itself there is a sidebar with links to interviews from various industry luminaries. It’s a nice feature and I hope they keep it up. But, you’ll have to follow the link below to see the interviews. Here’s the article [emphasis added below]:

U.S. Mortgage Crisis Rivals S&L Meltdown (Wall Street Journal, December 10, 2007, Greg Ip, Mark Whitehouse, Aaron Lucchetti)

‘The home has long been the bedrock asset of most American families. Now, its value has become the biggest question mark hanging over the global economy and financial system.

Over the past decade, Wall Street built a market for more than $2 trillion in securities sold globally and backed by loans to U.S. homeowners on two long-accepted beliefs and one newer one. The prevailing logic: The value of the American home would never fall nationwide, and people would almost always make their mortgage payments. The more recent twist: Packaging mortgage loans and turning them into securities would make the global economy more resilient if anything went wrong.

In a matter of months, though, much of the promise of the new financial architecture — together with its underlying assumptions — has proven to be a mirage. As house prices fall and homeowners default on mortgages at troubling rates, the pain has spread far and wide. An examination of the resulting crisis shows that it is comparable to some of the biggest financial disasters of the past half-century.

So far, the potential losses look manageable compared with the savings-and-loan crisis of the 1980s and the tech-stock crash of 2000-02. But the housing debacle could yet take years to work out, thanks to the sheer complexity of it. Until the mess is cleaned up, investors will remain jittery and banks will likely hold back on all kinds of lending — a credit crunch that is already damping global growth and could tip the U.S. economy into recession…

‘…Veteran financiers see in the current episode a pattern consistent with classic financial manias: Investors’ enthusiasm for an asset — in this case U.S. houses — drove up prices, attracted more capital and lifted prices to levels that preordained a fall. Home prices rose sharply elsewhere, too, including in the United Kingdom, parts of continental Europe and Australia. “Old fogies like me expected the bust to come earlier than it did,” says George Soros, the 77-year-old chairman of Soros Fund Management. “A lot of us got tired waiting for it.”

The Extent of the Crisis

The ultimate extent of the crisis will depend largely on how steeply the price of the average American home falls. That will play a pivotal role in determining how many people are at risk of foreclosure as payments on adjustable-rate mortgages tick upward and in the size of losses on securities backed by those loans. It will also affect the size of the hit that consumers sustain to their spending power.

House prices are down by 0.5% to 10% now, depending on the measure used. If they fell 30% — what it would take to restore their historic relationship to inflation, rents and incomes — $6 trillion worth of housing wealth would be wiped out. Measured against the size of the U.S. economy, that is less than what was lost in the stock market between 2000 and 2002. Initial guesses at total losses on subprime and similar mortgages range from $150 billion to $400 billion…

…Banks are far less exposed to serious damage than during the 1980s. Nonetheless, the shift of loans from banks to markets has created a staggering complexity that threatens to prolong the crisis…

…Housing fits a pattern Mr. [George] Soros has observed since he entered the investment business in the 1960s. Economic fundamentals, he posits, are supposed to determine asset prices. But often a flood of capital makes an asset’s fundamentals seem sounder than they really are, attracting even more capital. “Eventually, you reach a turning point,” he says, “where the value of the collateral begins to decline, which reduces the willingness to lend, which reinforces the fall in the value of the collateral.”

“There usually has to be a flaw in people’s perceptions to set a boom-bust sequence into motion,” Mr. Soros says. In the case of housing, he says, it was the assumption that, because home prices fall nationwide only in a severe economic slump, a diversified portfolio of U.S. mortgages made for a very safe investment.

Robert Shiller [see Major Turning Point? — Robert Shiller], a Yale University economist who has made a career out of studying bubbles, says the last bear market in stocks may have also made houses more appealing. A 2003 survey of home buyers he conducted with a colleague found 10 times as many said the stock market’s collapse encouraged them to buy a home as said it discouraged them. Their thinking, Mr. Shiller says, went like this: “I’m fed up with the stock market, I had so many promises of high returns and my broker and the accountants were deceiving us. But homes have always gone up in value, and it gives me great satisfaction to own a home and I can see it everyday.”

At first, home prices rose for good reason. With the economy in recession, the Fed slashed interest rates in 2001 and kept them low until mid-2004. That, plus an influx of foreign savings to the U.S., kept mortgage rates low. Former Fed Chairman Alan Greenspan frequently argued there could be no housing bubble. The high cost and inconvenience of moving “are significant impediments to speculative trading and…development of price bubbles,” he said in late 2004.

But rising home prices may have given both buyers and lenders a false sense of the market’s stability and security…

…When the Fed began to raise interest rates in 2004, mortgage rates also began to climb. Initially, home prices kept rising as home buyers turned to mortgages with low initial payments, assuming they could sell or refinance before the mortgage rate adjusted higher. Borrowers who had trouble making payments could easily buy more time by refinancing into bigger loans, thanks to higher prices. That kept defaults low and encouraged rating agencies to continue blessing securities backed by such mortgages with high ratings…

…In spite of the gloom, the economy may avoid recession. Housing comprises a much smaller share of the economy than business investment, which dragged the U.S. into recession in 2001. Also, the rest of the world is stronger than in 2001, boosting U.S. exports. For the entire U.S. economy to contract would probably require a broad decline in consumer spending, which hasn’t happened since 1991.

And, while financial problems are serious, they aren’t — at least yet — on a par with those of the 1980s, when many major banks would have been insolvent had they valued their Third World loans accurately. There is, indeed, a possibility that the opacity of today’s mortgage securities means markets may be factoring in far larger losses than will actually occur. Though the Fed is still worried about inflation, it has plenty of room to cushion the economy with additional interest-rate cuts…’

As this fine article mentions, this is yet another in a long line of crises that come about due to financial innovation. In my experience, most such innovations go to extremes and then, eventually, get incorporated into the routine fabric of our financial life. As we wrote in Gaining From the Subprime Meltdown,

‘As we slog forward, mired in the morass of the subprime meltdown, we see a ray or two of light, hope and even historical perspective. Writing in the Washington Post, Sebastian Mallaby, points out in this column that we have seen many similar cycles before [emphasis added]:

‘The meltdown in financial markets may seem scary or mysterious, but it’s part of a time-honored story. In Chapter One, a new financial instrument makes capital available to a new class of borrower, and the result is profits for the innovator along with gains for consumers. In Chapter Two, a group of not-so-smart investors misunderstands the novel instrument and bids its price up too enthusiastically; when the inevitable bust follows, the innovation is denounced as inherently dangerous. Then, in Chapter Three, the complaints blow over. The not-so-smart investors learn their lesson and the new instrument stabilizes. Financial innovation turns out to be beneficial without being scary, but by that time another newfangled instrument has emerged to frighten people, and finance is hauled before the court of public opinion — again…

Mr. Mallaby has it exactly right. Our capitalist system periodically does go to extremes or excesses. And, for every boom, there is usually a bit of a bust. But the net result is that the innovation has been tamed and adds value…’

For many years, the American home simply rose in value, year after year with few interruptions. Homeowners, realtors, lenders and investors simply assumed that the trend would continue indefinitely. Like all trends, this one has ended. It does not mean that homes are never going to rise in value again, but rather that home values are subject to market conditions like every other asset. And, in this case, after many years of appreciation, everyone involved needed to be reminded of that four letter word — RISK.

• Business , Economy , Investing , Money
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